OPTIMIZATION MODELS

Many firms have small surpluses available for short periods of time; we need, therefore, to address the problem of trade-off between investment income and transaction costs of investing and disinvesting. In this regard, we may mention about four models that provide optimum strategies for investment and disinvestment when transaction costs play an important part. These models are the Baumol model, the Beranek model, the Miller-Orr model, and the Stone model. Each of these models provides optimum strategies for a given time pattern of cash flows.

The miller-Orr and Stone models explicitly address the risk in the net cash flows, while the Baumol and Beranek models assume certainty. To choose among these models, the first step is to match the time pattern of the firm’s cash flows to the time patterns assumed in the models. This match should be based on the specific of the firm’s business policies that affect cash flows (how often payments are made to suppliers, the firm’s terms of sale, and so forth) and on empirical investigations of the time pattern of cash flow. The latter investigations might include time plots of net cash flow and statistical comparisons of net cash flows with known probability distributions.